Market Review 4 May 2010

Over the weekend, the Euro area and the IMF together pledged a joint commitment of €110 billion or $145 billion for Greece.  In effect, this covers Greece’s anticipated debt service through to June 2012.  That debt service includes all maturing bonds and bills and the cost of further anticipated current account deficit.  This is clearly a larger amount than was originally intended but it is accompanied by a significantly more detailed budget deficit reduction programme than was envisaged in September 2009.

Partnership with the IMF is clearly helpful and the IMF’s statement contains precise language, for example, involving the “abolition of the 13th and 14th salary together with sharp reductions over time in the size of the state pensions”.  We suspect it is a mistake, though, simply to focus on the size of the Greek deficit funding programme.  Whatever the size, if the Greek government’s budget deficit and debt position are not reduced to sustainable levels, any loan would only postpone an inevitable default.

Alongside the measures announced at the weekend, the European Central Bank indicated that it would ease its collateral rules on existing sovereign paper.  In effect, the ECB is now willing to take an unlimited volume of Greek government paper through the secondary market despite the fact that on 27 April the S&P downgraded Greece three notches from BBB+ to BB+.  Greece is no longer in the investment grade universe but the ECB has changed its rules to accommodate Greece.  The S&P also downgraded Portugal from A+ to A-.  For the time being, Spain remains AA+ having been downgraded last in April 2009.

During the course of the last two weeks, Greek government debt has fallen sufficiently sharply to discount an element of default.  In effect 10-year Greek paper has dropped from 100 to 77 between mid March and the end of April.  The IMF has had a lot of experience of dealing with countries in need in the last few years.  During the financial crisis of 2008, several eastern European countries received IMF financial help – Hungary, Latvia, Romania, Ukraine and Serbia.  In all those cases, these countries had large current account deficits making them vulnerable to potential halt or reversal of capital flows.  This vulnerability was exacerbated by the presence of foreign currency lending to the private sector.  None of these countries, though, had quite the combination of high government debt and large cyclically adjusted budget deficit of Greece.  It seems clear that Greece has a particularly tough problem.

To be successful in the intermediate term, Greece has to be able to restore GDP growth sufficiently to reverse the rise in government debt to GDP ratio and ease the social pain of adjustment.  As fiscal tightening squeezes domestic demand, exports have to become the key driver to economic activity during the period of fiscal denomination.

Hitherto, the role of the ECB in this crisis has been a secondary one.  However, by reneging on its pledge in January not to loosen its lending ‘requirements for the sake of one particular country’, the basis of European monetary policy has clearly shifted.  The way has been opened up for the ECB to behave in a similar manner in respect of Portuguese or Spanish debt.  European monetary policy may have to ease sharply in the months ahead.  Since October 2008, the quantity of Eurozone M3 money has been unchanged.

In anything other than the short-term this would be a problem.  With banks in Portugal, Italy, Ireland, Greece and Spain worried about their ability to finance new assets and avoid new loans to the private sector, M3 money could well stagnate for longer.  Deflation in these countries will intensify, risking a break-up of the Eurozone.  If the ECB wants to rescue the Eurzone, it needs to take early action to boost the quantity of money.  Maybe this is the first preparatory step.

The next response to a broadening loss of confidence in the euro area finances would be for the ECB to channel cash through banks, either by lending them more for longer in its regular auctions or by weakening collateral rules further.  There is a good chance the ECB will ultimately have to resort to quantitative easing.   The immediate prospects for the euro remain clouded.

Meanwhile in Australia, the government has succumbed to political temptation in proposing a mining super tax to fund infrastructure and social spending.  Resources companies make up 9% of the Australian economy and warned last week that a 40% additional levy and double taxation with payments to states would threaten $108 billion of planned capital investment.  BHP, with 51% of its assets in Australia, indicated that taxes on its operations there would increase to 57% in 2013 from 43% now.  The tax could reduce BHP’s earnings by 17% and Rio’s by 21% in 2013.  Hardly surprisingly, the Australian equity market and by extension parts of the UK equity market have been suffering.  Fortunately, we have nothing in Australia and, as of the end of last week, nothing in continental European equities.